Thursday, May 4, 2017

Modification of a Trust with a Private Letter Ruling

Often, tax payers will submit a written request to the Internal Revenue Service (IRS) for a Private Letter Ruling (PLR).

A PLR is a written statement issued to the taxpayer in which the IRS applies the tax laws to the set of facts provided by the tax payer. Although PLRs may not be relied on as precedent by other tax payers, they do provide guidance for taxpayers, attorneys, and financial planners.

Recently, the IRS issued PLR-120963-16. In this particular PLR, the taxpayers were looking for clarification regarding the interpretation of specific sections of an irrevocable trust. Before September 25, 1985, the Trustor created an irrevocable trust for the benefit of his three daughters: Daughter 1, Daughter 2, and Daughter 3. Upon the Trustor’s death, three individual trusts were to be created for the Daughters. Each daughter was to be the Primary Beneficiary of the trust created for her. Additionally, upon the death of the Primary Beneficiary, the Trustees were instructed to divide such trust into as many equal parts as there were children of the Primary Beneficiary and then to any issue of those children.

However, the trust agreement did not address what would happen to assets to be distributed should the Primary Beneficiary die without any surviving children. Further, the trust agreement did not contain a dispositive provision for shares allocated to the issue of a deceased child of the original Trustor’s Daughters. At the time the Trust was created, the Trustor was not aware that the trust agreement did not contain these particular provisions.

The then acting Trustees submitted a petition to modify the term of the Trust in order to resolve the above listed ambiguities. However, the requested modification raised an important question: would a judicial modification negate the Generation-Skipping Transfer (GST) Tax exemption contained in the Trust? Under Section 26.260-1(b)(1)(ii) of the GST Regulations, the tax does not apply to any generation-skipping transfer from a trust, if the trust was irrevocable on September 25, 1985, and no addition (actual or constructive) was made to the trust after that date. However, Section 26.2601(b)(4) provides rules for determining when a modification, judicial construction, settlement agreement, or trustee action will not cause the trust to lose its exempt status. Section 26.2601(b)(4)(i)(C) states that a “judicial construction of a governing instrument to resolve an ambiguity in the terms of the instrument or to correct a scriveners error will not cause an exempt trust to be subject to the provisions of chapter 13 if (1) the judicial action involves a bona fide issue; and (2) the construction is consistent with applicable state law that would be applied by the highest court in the state.”

In this instance, the two omissions in the Trust discussed above not only created ambiguities in the Trust itself, but also qualified as a bona fide issue. Because the modifications in question met the two standards previously discissed, the Trust would not lose its GST exempt status. In fact, a judicial modification of the Trust aligned the Trust Agreement with the Trustor’s original intention: to provide for his Daughters and, in the event that Daughter 1, Daughter 2, or Daughter 3 left no surviving issue, then the Trust would provide for the the then-living issue of any deceased Daughter.

While PLRs are not precedent, this particular case serves as a warning for attorneys and financial planners alike: carefully draft your client’s documents to meet their goals and objective while making sure not to omit necessary information that may cause the trust to lose an important exemption status.